Near-Rational Behaviour and Financial Market Fluctuations.

This paper departs from the conventional assumption of unbounded rationality in the marketplace and investigates the effects of a suboptimal behavior in financial markets. A rule of thumb adopted by a group of agents is proven to be near-rational, in the sense that the costs borne by those agents are negligible. The paper argues that despite the insignificant consequences of the near-rational behavior from an individual standpoint, it can cause asset prices to significantly deviate from their rational equilibrium levels. Moreover, the impact of near-rational agents is found to be disproportionately large. The presence of near-rationality causes excessive volatility in observed market prices, as it amplifies the effects of an income shock on the financial market. Copyright 1993 by Royal Economic Society.